Seeking Alpha
Value, contrarian, long-term horizon, activist investor
Profile| Send Message|
( followers)
Just under a year ago, I published an article on Seeking Alpha entitled Tremendous value found in China North East Petroleum. At the time I exposed the fundamental reasoning on why this company was bound to appreciate in price throughout 2009 and beyond; 12 months later it seems that China North East Petroleum “China North” (NYSEAmex: NEP) has lived up to expectations with the stock rising more than fivefold from its price in January 2009.
After such a stupendous rise, an investor in China North is certainly interested in knowing whether the company has reached its fair valuation, and whether there is more upside to come? My short answer to the first question is: “No” and to the second is: “There is much more upside to come.”
The reason for my continued optimism is derived from a number of developments that took place within 2009 and a number of catalysts expected to take place in 2010:
2009 Achievements:
  • Resiliency: In 2009 all oil companies experienced a very difficult operating environment, and especially so in the first half, oil prices sunk to a low in the $30s, financing options were severely curtailed and oil demand sunk for the first time on a global basis since the oil shocks of the 1970s, yet China North managed to maintain its profitability, increased its production, and is on its way to a record year in revenues and cash flow due to its smart navigation of the crises and strategic expansion into oil drilling.
  • Listing: In June 2009, China North managed to secure a listing on a major exchange: the NYSE Amex (You may refer to my article: China North East Petroleum Catapults to the next Level – June 18th). This listing has radically changed the perception of the company in the market place, it has invited a significant and growing institutional ownership, such as the position taken by High Bridge Capital, a division of JP Morgan (NYSE: JPM) and Black River Asset Management (a division of the Cargill group, the world’s largest private conglomerate).
  • Acquisition of Song Yuan Tiancheng Drilling “Tian”: The acquisition of Tian is of tremendous strategic importance to China North, Tian is the largest private driller working for PetroChina (NYSE: PTR), the acquisition of Tian has led to an effective 50% increase in revenue estimates for 2010, it has significantly diversified the company's business away from fluctuating oil prices, and away from China North's expected increased royalty in 2012. Finally, the deal has positioned China North very favorably to being PTR’s chosen partner to develop new oil fields in the Jilin oil field and elsewhere throughout China.
Other accomplishments of importance in 2009 include the 200% increase in proven reserves to 5.4m barrels from 2.5m in 2008 out of a total OOIP of 75 million barrels. The strengthening of the management team with the addition of the seasoned executive Mrs. Hongwei Lu to head the Tian drilling division; the initiation of brokerage coverage, and finally the full repayment of the company’s outstanding debt and significant increase in the company’s cash position.
While the accomplishments in 2009 present a qualitative and quantitative leap for the company business, they remain only the preliminary stepping stones in the company’s long term development plans. In 2010, we should expect further key steps and catalysts that should take the company another notch closer in its aspirations to becoming a key player in the Chinese private oil industry. The most important development to be expected in 2010 (likely within the next 6 months) is securing additional reserves, China North management has been persistent and diligent in its work to secure new oil reserves. The company is following a dual agenda to achieve this goal:
  • The purchase of a competitor: China North has reiterated its interest in acquiring some of the 36 private oil companies operating in the Jilin oil field, many of those private players are much smaller, none publicly traded and have limited access to capital, China North plans to consolidate several of those players under its umbrella, thus creating a much larger and significant oil player; in the company’s November 20th 2009 Brean Murray China Growth conference presentation, management underlined their plans to act as such a consolidator.
  • The signature of new leases with PetroChina: China North management has indicated that PetroChina is planning to award new development leases to the likes of China North, however to have access to such a lease, the awarded partner needs to demonstrate a strong development track record, have sufficient financial and logistical resources to develop the awarded fields. China North today satisfies both of those requirements, and it is only one out of two private players that have been invited to submit development bids for such fields in the last 6 years (Highlighted during C.K. Coopers & Equities magazine investment conference company presentation in Sept 17th 2009).
In addition to the above, the company is working to increase its proven reserves organically, through the drilling of new oil wells, and the application of the Security and Exchange Commission’s new regulation for the disclosure of oil reserves through the application of new technology such as 3D seismic analysis. If China North is successful in applying those new regulations, its proven reserves category will expand significantly. The deadline for the application of the new regulation is March 31st, 2010.

The award of a new lease from PetroChina or the acquisition of a competitor will have a powerful impact on the valuation and perception of the company, investors are strongly advised to hold shares in the company ahead of such an announcement.
Valuation
Despite the fivefold increase in the company’s value over the last 12 months, China North East Petroleum remains extremely undervalued vs. its peers. It trades at roughly half the industry Price to Earnings (11 vs 21), it also trades at a significant discount in terms of Price to Sales, Price to Cash flow and Enterprise Value to EBITDA (key metric for energy stocks). The company trades at a discount despite its much stronger historic and expected growth profile, according to the latest broker estimates for 2010, the company is expected to double its revenues to about $120 million dollars and increase earnings per share by over 60% to $1.2 per share year over year (based on $65 average oil price). Furthermore, the company continues to enjoy significantly higher ROE, ROA, ROC, gross margin and net margin in comparison to its peers.
Short Term Catalysts
The next few quarters should witness a surge in the company top line and bottom line results, due to a combination of several factors. The company has resumed its production growth through the addition of 25 wells in Q4-2009, followed by continued accelerated drilling in 2010. The effect of the increased production will show in the company Q4-2009 results (set to be released in March of 2010), furthermore, the substantial increase in oil prices in the last few months will translate into a major boost to the company results over the short term, as we enter a period of easy year over year comparisons.
Finally, the introduction of the Tian drilling division revenue stream will add a new source of revenue and earnings growth. Those three factors will lead to an estimated threefold increase in revenue and earnings per share in Q1-2010 results (set to be released in May 2010). Similar strong year over year results are expected throughout the year and especially if oil prices maintain their current level or appreciate further.
Long term potential
Investing in China North today is akin to investing in Ultra Petroleum (NYSE: UPL) or Arena Resources (NYSE: ARD) at the start of this decade; both of those companies started as small independent oil extractors and developers similar to where China North stands today, yet China North enjoys a significant advantage: The competition in the Chinese private oil industry is much less in comparison to the operating environment for US independents. Furthermore, the operating costs are much lower in China, yet China North oil is priced according to international benchmarks, thus offering the company a substantial spread for each oil barrel sold.
The company's low cost production base, significant organic and M&A growth potential, and most importantly, management's demonstrated ability in creating shareholder value offers a unique long term opportunity for current investors to enjoy above average returns from their investment over the next few years.
However, being right on the future of China North East Petroleum or the direction of oil prices is not enough for an investor to reap the rewards of such foresight. He or she needs to be invested and fully committed to their investment. This is why I would like to finish this article with a paragraph from “Reminiscences of a stock operator”, by Edwin Lefebvre, which is a biography of possibly the best trader / investor who ever lived - Jesse L. Livermore. Livermore states:

"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine--that is, they made no real money out of it. Men who can both be right and sit tight are uncommon."


References:
November 20th 2009, company presentation
Company latest 10Q:
Tian Acquisition Press Release:
Appointment of Mrs. Hongwei Lu:
Institutional holdings:


Disclosure: The author is long China North East Petroleum (NYSEAmex: NEP)
Source: Why I Am Still Long China North East Petroleum